Second Anniversary of Credit Meltdown: A Faith Based Rally

Today is August 3, 2009. It is the second anniversary of the modern day version of Black Monday. Two years ago today, financial markets started a meltdown. That, in turn, brought down the financial institutions that held the assets that were melting down and in turn, shortly thereafter, brought the economy down to its knees as well. We are now in the seventh quarter of a recession which is the longest post World War II recession, a recession now called by economists “The Great Recession.” The good news is we managed to avoid a Great Depression. The way we managed to avoid that is some very aggressive Federal Reserve purchases of financial assets as well as some very aggressive, unprecedented government purchases of assets, as well, called the TARP program. Between the two aggressive programs, we saved or stopped or avoided or averted the continued meltdown of financial assets and financial institutions, but it also generated a great deal of concern over future inflation as well as the financial viability of the US government.

About two weeks ago, the Fed, in a very masterful, tactical stroke, started to recapture expectations of inflation that it generated. The way they did this was to have an unprecedented Town Hall meeting that was nationally televised to talk about “their exit strategy.” Their exit strategy means we are going to contract all the lending we have been doing and also, in doing so, we contract the monetary aggregates so that there is no fear of inflation ahead. Basically what they did was recapture inflation expectations. Also, what occurred in the discussion of their exit strategy was a presumption that an exit strategy could occur because the economy is somehow healed at this point. So it generated expectations of reasonable price activity as well as a recovering economy. The stock market responded to that and added to a rally that had already been underway since early March. In fact, in July, the stock market probably had one of the strongest Julys on record. We now are in somewhat of a quandary as to what all this means, in that we are having a stock market recovery but yet the economy is floundering.

What is the stock market trying to tell us? Or, moreover, what is the mindset of investors who are investing in the stock market and what might we be possibly anticipating and contemplating as stock investors? Well, typically a stock market advance is based on a forecast, a forecast of where the economy is going. The forecast of where the economy is going is typically supplied by 75 or so professional forecasters typically working for stock brokerage firms who approximately semi-annually forward their forecast to the Wall Street Journal, which then tabulates the mean or the average of the forecasters’ forecast and publishes it. This typically is a nonevent in that the forecasters typically do not do anything more than extrapolate past trends. There is a decent reason for doing so, and that is the economy is a great momentum machine and that is if there is production taking place today, those who produce those products will be paid income, and then we can very much count on them spending virtually all of it so that production generates income which produces spending. In turn, the spending produces the next stimulus for production, income generation, spending. So around and around we go with production, income, spending, production, income, spending. The only way that stops is that there is some kind of a sharp loss of confidence and the spending stops, as indeed occurred in 2007. So it is very easy for the economists to simply trend extrapolate the past forward. Given the trend extrapolation forward of the economic growth rate, then stock market analysts very faithfully project forward firm revenues and firm profitability into the future and come up with their forecast of stock price valuations. At the core is the future projection of the economy which ironically is based on a trend extrapolation of the past.

Now we are in a dilemma for forecasters and the stock market. That is that we have had seven consecutive quarters of negative economic growth. If that gets projected forward, we are pointing toward a GDP of zero, which cannot happen, and stock prices of zero, which cannot happen. So our forecasters had to abandon the trend extrapolation method and actually start thinking about it for the first time. What has occurred instead of one single forecast of extrapolation of growth, what has occurred are two separate forecasts of the future, two different groups of people with two different totally directional forecasts. One is rosy and the other is glum. The rosy forecast typically is made by those who are stock market participants either as stock brokers, money managers, etc. Their experience since 1946, and they have a long period of history to look at to have confidence, is that since 1946 the Fed has been mandated by law to intervene and save the economy from recessions. The usual mechanism as occurs today is very low interest rates and the availability of credit. The Fed can, in turn, count on us as consumers or investors borrowing from banks and then spending. So it has been a very reliable mechanism. The Fed monetary policy has been a very reliable mechanism to prevent recessions from continuing at great length. In fact, over the last 25 years prior to the current event, the two minor recessions we have had were extremely short-lived and very quickly reversed. So given that history of successful manipulation of the economy by the Fed, the stock market analysts and stock market investors and the stock market industry forecasters are very confident of a rosy future, particularly after such a sharp drop that did occur in financial prices. Basically, since January, both debt and equity prices have risen not only in the United States, but across the world.

So that is one forecast. The other forecast that you also hear, which puts us into dissonance as stock investors, is the hard core group of realist economists who look at the current economic situation and see it as being very different from any economic situation we have been in before. They see the slippery slope of economic recovery and really are not confident of economic recovery occurring anywhere in the immediate future. Most of them see it being a “U-shaped recovery” with no exact idea of how long we will be in the bottom of the U. Very plausible cases can be made that we are still going down, credit is still contracting and delinquencies are rising, commercial real estate in particular, so the process of wind down is still occurring. They do not see any immediate end to it.

So what we have now are two loud and clear groups with two different forecasts. One is of a rosy, bright future with a positive forecast of economic growth and the other Doom-and-Gloomers see that the economy, if not continuing to contract, at least will sit at a very low level of activity for a prolonged period of time.

What does one do as a stock market investor? Which of these two schools of thought do you take as comfort for whether or not to enter into the stock market advance at this point. Or, if you have, whether to stay there? Basically, the stock market train started pulling out of the station on, I believe, March 2, and now it has picked up momentum in July. Most of the major indices have increased somewhere in the order of 40-45%. So the question becomes the anguishing decision of a stock investor as to whether to jump on the train at this point when there is a very logical case that could be made that we will have a train wreck ahead. So what does one do? Basically, what we have on one hand is a faith rally. Incidentally, what the rosy-eyed optimists have observed is not just that the Fed saves us, but that in the past the stock market has always advanced forward before the economy has advanced. They feel they can be rosy in their outlook without any indication of economic advance because that is not necessary for a stock market advance. On the other hand, the other group has to see some firm foundation of economic advance to generate spending, to generate firm revenue, to perpetuate increase in profitability.

So we now have this dilemma. Which of these two forecasts to believe in and act upon? It is a difficult situation, an extremely difficult situation, because what we have had is a situation where expectations of the rosy future really have departed from the reality of a rosy future. What does one do? The faith-based rally is based on confidence of the future and has gathered more fuel in July because so many stock analysts had to jump on the train because basically their job is at risk if they somehow under-perform the market. They have underperformed very badly the last two years and three years in a row. Typically is the formula to be fired. We have had more fuel thrown into the faith-based rally and the doubters are becoming more doubtful. It becomes an excruciatingly difficult decision to make for stock market investors. All that I can say is that rather than examine the underlying economy which we can presume not to mend itself in any significant way over the next year or two, take a look at the market fundamentals of the strength of the rally and how much more funding the enthusiasts have to throw into the market and to bid prices up. That has occurred. It has occurred very significantly in July, where institutional cash has been reduced significantly, short positions have been reduced significantly. In fact, one can make the case that this is to some extent a short covering rally.

So the market fundamentals will have to be examined very carefully right now, more so than the economic fundamentals. I think we can take as a given that the economic fundamentals are weak. The question is are the stock market fundamentals weak or strong. What I mean by that is will prices continue to advance on high volume. That is probably the most significant indicator of where the market goes from today. But meanwhile, I have really no answer to the question as to which camp to join. The problem is if you really are a pessimist, as indeed I am, how does one jump on the train at this point where you see the possibility, and the strong possibility, of continued problems ahead. It is a very frightening experience, as I say, and the only thing you can use as a guide is current financial market technicals. That is something to pay attention to if you do care to jump on the train.

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